In the World
Central banks indicated easier policy amid softening economic data and an uncertain trade outlook. The Federal Reserve, the central bank of the United States, dropped the word “patient” from its policy statement and instead signaled that it would act as appropriate to sustain the expansion, which is set to become the longest in U.S. history in July. The U.S. Federal Open Market Committee (FOMC)’s June statement emphasized higher economic uncertainty, which contributed to roughly half of FOMC officials forecasting 50 basis points (bps) in policy rate cuts by December. Even many of those who did not forecast a cut did “agree that the case for additional accommodation has strengthened since the May meeting.” Other developed market central banks echoed these sentiments. The European Central Bank (ECB) suggested additional stimulus in the form of rate cuts or quantitative easing may be required; the Bank of Japan hinted that it may allow 10-year government bond yields to fall below the –0.2% floor; and Australia’s central bank cut its overnight lending rate to a record low of 1.25%. Underlying the widespread dovishness were further signs of decelerating growth – notably declining manufacturing PMIs – and ongoing global trade tensions. However, some reprieve occurred at the G20 summit as U.S. President Donald Trump and Chinese President Xi Jinping agreed to proceed with trade negotiations. In a positive surprise, Trump announced he would allow U.S. companies to do some business with China’s Huawei Technologies, a previous target of the U.S. administration. Elsewhere, the U.S. “indefinitely suspended” scheduled tariffs on Mexican goods after negotiators reached an agreement on immigration enforcement.
“Safe-haven” and risk assets alike rallied on the heels of increased central bank accommodation globally. The dovish shift from developed market central banks, coupled with more uncertainty over the state of the global economy, sent government bond yields lower: The U.S. 10-year Treasury yield fell below 2% for the first time since 2016, and the German 10-year bund rallied 13 bps to –0.33% (a new low). In fact, the volume of negative-yielding sovereign debt around the globe reached a record of more than $12 trillion. The Fed’s dovish rhetoric also sent the U.S. dollar lower against most developed and emerging market currencies, while gold rallied more than 8%, reaching its highest level since 2013. Meanwhile, global stocks bounced back after a volatile May, with the S&P 500 climbing 7% to approach record highs. Credit spreads also tightened, particularly in high yield markets where spreads rallied more than 50 bps.1 The positive momentum in both risk assets and traditional “safe-haven” assets (including Treasuries and gold), suggested an environment where “bad” news was good news: Negative economic developments were received positively by most markets in anticipation of central bank easing.
Outside of trade, several notable geopolitical developments garnered headlines. Volatile relations between the U.S. and Iran further escalated after two oil tankers in the Gulf of Oman were attacked and Iran shot down a U.S. drone. The U.S. initially threatened to retaliate with a military strike before pulling back and instead imposing additional sanctions. Iran responded by warning it would increase its stockpile of enriched uranium beyond the limit specified in the 2015 nuclear deal if the remaining signatories of the nuclear deal did not assist in easing U.S. sanctions. The escalating tensions managed to push the price of oil 3.2% higher despite data earlier in the month that showed rising inventories in the U.S. and slowing global demand growth. In Hong Kong, hundreds of thousands of citizens flooded the streets to protest a proposed bill that would allow for the extradition of Hong Kong citizens to mainland China. Lastly, in the UK, the 2019 search for Prime Minister Theresa May’s successor was underway, with Boris Johnson leading the Conservative Party polls by a wide margin.
In the Markets
Developed market stocks1 recovered sharply from May’s selloff and ended June 6.6% higher, reaching a new intra-month high for the year. U.S. equities2 climbed 7.1% as market participants reacted to the higher probability of the U.S. Federal Reserve cutting interest rates and the improving outlook for U.S.–China trade negotiations. European3 equities increased 4.4% and Japanese equities4 rallied 3.4% as improved global growth prospects and increasingly dovish commentary from the European Central Bank (ECB) aided the recovery in developed markets broadly.
Emerging market5 equities rallied 6.2% overall in June, with broad participation across countries. Chinese6 equities rose 3.7% due to the improving outlook for U.S.–China trade. In India7, stocks fell 0.5% on higher energy prices, which have the potential to weigh on India’s import-dependent economy. Conversely, Russian8 equities rallied 5.7%, given the country’s reliance on fossil fuel exports as a primary source of economic growth.
DEVELOPED MARKET DEBT
Developed market yields broadly declined in June as central banks indicated that a softening economic backdrop may warrant more accommodative policies ahead. In the U.S., the Federal Open Market Committee (FOMC) highlighted that mounting economic uncertainties made a stronger case for preemptive rate cuts. The U.S. 10-year Treasury yield dipped below 2% for the first time since 2016 and ended the month 12 basis points (bps) lower at 2.01%. Similarly, ECB President Mario Draghi noted that the bank was primed to initiate further stimulus, and leaders of the Bank Of Japan (BOJ) indicated a more flexible stance on its yield-curve control policy. The German 10-year bund yield shifted deeper into negative territory, declining 13 bps and ending the month at a record low of –0.33%, and the Japanese 10-year rate fell by 6 bps to –0.16%.
Global inflation-linked bonds (ILBs) posted positive absolute returns across most countries but generally underperformed their nominal counterparts in June as breakeven inflation expectations (BEI)9 moved lower on increasing downside risk in many economies. In the U.S., Treasury Inflation Protected Securities (TIPS) delivered positive absolute returns after a dovish Fed drove real yields to rally. The FOMC left rates on hold in June, dropped the word "patient" for "act as appropriate," and downgraded the growth outlook to "moderate" from "solid." U.S. BEI finished the month in the red, despite rebounding in mid-month following the dovish Fed messaging. Outside the U.S., European real rates generally fell in reaction to ECB President Draghi's statement that "additional stimulus will be required" in the absence of an improvement in the low inflation backdrop.
Global investment grade credit10 spreads tightened 10 bps in June, and the sector returned 1.98% for the month, outperforming like-duration global government bonds by 1.09%. Spreads tightened across all industries on the expectation of more accommodative central bank policies. Energy companies outperformed as geopolitical developments in the Gulf region drove crude oil 11% higher. U.S. financial companies also outperformed the market on the back of positive bank stress-test results.
Global high yield bond11 spreads tightened 54 bps in June. The sector returned 2.50% for the month, outperforming like-duration Treasuries by 1.73%. As in other markets, the rally followed dovish Fed and ECB developments, as well as optimism over U.S.–China trade negotiations. In June, the higher-quality BB segment returned 2.77%, while the CCC segment returned 1.45%.
EMERGING MARKET DEBT
Both local and external emerging market (EM) debt finished the month strongly positive, although local was notably stronger. External debt returned 3.04%12, aided by a substantial 69-bp tightening in spreads and a 14-bp move lower in the underlying U.S. Treasury yields.13 Local debt posted a higher return of 5.51%14 as local rates rallied substantially – following developed- market yields lower – and EM currencies benefited from a weaker U.S. dollar. Both subsectors benefitted from rising expectations of a rate cut in the U.S., given some weakness in economic data and dovish policy guidance from the Fed. The announcement of a temporary trade truce between the U.S. and China also boosted EM investor sentiment.
Agency MBS15 returned 0.72%, outperforming like-duration Treasuries by two bps. June was the ninth month of the Fed's balance-sheet unwinding; the Fed sold $20 billion (USD) in MBS over the month and has cumulatively sold $260 billion (USD). MBS outperformance was mainly driven by Ginnie Mae and 15-year MBS. Lower coupons outperformed higher coupons within the 30-year Uniform MBS (UMBS) stack; Ginnie Mae MBS outperformed Fannie Mae MBS, and 15-year MBS outperformed conventional 30-year MBS. Gross MBS issuance increased 4% to $119 billion, and prepayment speeds increased 18% in May (the most recent data available). Non-agency residential MBS spreads were flat during June, while non-agency commercial MBS16 returned 1.0%, underperforming like-duration Treasuries by five bps.
The Bloomberg Barclays Municipal Bond Index returned 0.37% in June, bringing the total return to 5.09% for the year. Munis underperformed the U.S. Treasury index over the month, however, and MMD/UST ratios across the curve. High yield munis continued to demonstrate strong performance, returning 0.52% for June and outperforming the investment grade muni index. This brought the year-to-date return to 6.66%. High yield performance was driven primarily by positive returns in the water & sewer and special tax sectors. Total muni supply of $34 billion in June was 21% higher versus the previous month and 3% higher year-over-year. Muni fund flows remained strong, marking 25 straight weeks of inflows: Investment inflows totaled $4 billion in June and $46 billion for 2019, still the strongest recorded start to a year.
The U.S. dollar ended the month substantially weaker (–1.7% based on DXY) than its developed-market counterparts on predictions of a rate cut by the Fed, in turn supported by some weakness in economic data and dovish policy guidance from the Fed. Dollar weakness even overcame the effects of dovish ECB rhetoric and lackluster German factory orders, and the euro strengthened 1.8% versus the dollar. Similarly, the British pound strengthened 0.5% against the dollar despite continued political uncertainty and a contractionary manufacturing PMI reading in the UK. The Japanese yen, a traditional "safe-haven" currency, benefited from geopolitical tensions associated with Iran and from weakness in the dollar to strengthen 0.4% against the dollar. Turning to emerging markets, the Chinese yuan was 0.6% stronger versus the dollar, supported by dollar weakness and a trade truce with the U.S.
Commodity returns were positive in June. Crude rebounded as geopolitical developments in the Middle East supported prices despite ongoing concerns about global economic activity and the pace of oil demand growth. After initially declining on reports of inventory build-ups in the U.S., oil staged a midmonth recovery amid flaring tensions in the Gulf. Prices were further buoyed after the U.S. Energy Information Administration (EIA) reported a 12.8-million-barrel decline in inventories, the most in nearly three years, with exports hitting a record high. The worsening trade outlook contributed to a downward revision to oil demand growth: The International Energy Agency (IEA) reduced its forecast by 100,000 b/d to 1.2 million b/d in 2019. Natural gas prices hit a three-year low as strong production and concerns that the U.S. might have to slow LNG exports due to weak global markets offset improvements in demand. The agricultural sector was flat in June. Soybeans and corn rallied into midmonth amid continued rainfall in the U.S. Plains and Midwest regions, and the latter benefitted further following the release of the U.S. Department of Agriculture's WASDE (World Agricultural Supply and Demand) report, which estimated this season's ending stocks at 1.7 billion bushels, the lowest since 2013–2014. Markets for both crops later pared gains, however, on forecasts for dry weather, and corn continued to decline following the USDA's surprise increase to planted area in its June Acreage Report. Despite ongoing concerns about demand for metals, prices rose in June on optimism around U.S.–China trade talks. Precious metals posted solid gains; gold prices topped $1,400/oz., the highest level since 2013, as Treasury yields fell on expectations for looser monetary policy and slowing global growth; palladium surged, outperforming platinum's rise.
Based on PIMCO’s cyclical outlook from March 2019.
In the U.S., we continue to expect growth to slow to 2%–2.5% in 2019 from nearly 3% last year. Factors contributing to the deceleration include fading fiscal stimulus, the lagged effect of tighter monetary policy over the past few years, and headwinds from the China/global slowdown. Headline inflation is likely to remain in the 1.5%−2% range this year, while core CPI moves sideways. With growth likely to continue slowing through the year and inflation remaining below target, the Fed has adopted a more dovish stance and looks likely to cut rates by 50 basis points (bps) by year-end 2019.
For the eurozone, we expect growth to slow to a trend-like pace of 0.75%–1.25% in 2019 from close to 2% in 2018, as weak global trade exerts significant downward pressure on the economy and some countries experience a recession. An improvement in global trade conditions would contribute to a gradual reacceleration. Reflecting firmer wage growth, we expect a modest pickup in core inflation, which has been stuck at 1% for some time. Mirroring the dovish shift by many central banks, the European Central Bank (ECB) has also taken an accommodative tone with some potential for more easing policies in 2019.
In the U.K., we expect real growth in the range of 1%–1.5% in 2019, modestly below trend, and we continue to think that a chaotic no-deal Brexit is a lower-probability event. We see core CPI inflation stable at or close to the 2% target as import price pressures have faded and domestic price pressures remain subdued.
Japan’s GDP growth is expected to be modest at 0.5%–1% in 2019, broadly unchanged from 0.7% in 2018. With core CPI inflation expected to dip into negative territory (due to temporary factors), we expect the Bank of Japan to keep its targets for short rates and the 10-year yield unchanged this year.
In China, we see growth slowing in 2019 to the middle of a 5.5%‒6.5% range from 6.6% in 2018, stabilizing somewhat in the second half of the year as fiscal and monetary stimulus find some traction. We expect fiscal stimulus of 1.5% to 2% of GDP. Inflation remains benign at 1.5%-2.5% in our forecast, and we may see additional stimulus if credit conditions deteriorate more. Yuan stability is well-anchored with a patient Fed and the understanding that this needs to be a component of the China−U.S. trade deal.